Breaking down the Wall

After years of false starts, half measures and regulatory reversals, it looks like 2019 is the year that the Chinese securities lending market finally opens up for international participation. Nick Lord reports on the latest moves that suggest the year of the pig could be one to remember.

On January 31, 2019, just as China was about to break away for the annual lunar New Year festivities, the China Securities Regulatory Commission (CSRC), announced a slate of new, draft regulations that expanded access to Chinese domestic equity markets for those investors who operate under the QFII regime. They have doubled the total quota to $300 billion and merged the dollar and offshore renminbi (RQFII) regimes.

They also relaxed the rules on domestic fixed income securities lending and repo, so as to essentially give foreign and domestic investors the same access to the markets. They also announced that QFIIs can participate in equity securities lending and margin trading. Many are now optimistic that after years of delays, 2019 could be the year in which finally, full access to Chinese stock lending could become a reality.

“There have been several announcements in the last few months about development of and continued liberalization in access to the China repo market,” says one leading securities services banker in Hong Kong. “We expect the initial levels of access, which already exist for certain channels and counterparty types, to increase quite significantly over the course of 2019.” The announcement has come after years of lobbying by international banks and brokers, who have been clamouring for increased access to the domestic Chinese equity market.

Spearheading much of that effort has been Asifma, the Asia Securities Industry and Financial Markets Association. “Global institutional investors are greatly encouraged by the increasing speed of market reforms in China,” says Lyndon Chao, Managing Director and Head of Equities at ASIFMA in Hong Kong. “Key areas of prior concerns such as high numbers of trading suspensions and market intervention via window guidance have all been addressed at a pace which surprised the industry. As investment channels into China’s A-share market continue to improve and as effective and efficient hedging instruments become more readily available to institutional investors, substantial capital flows into China can be expected to continue to increase.”

Equity market players have enjoyed a slow but steady opening of the domestic Chinese market in recent years. The Stock Connect system dramatically improved access to the domestic Chinese equity markets at the end of 2014. This added another dimension to the existing QFII quota system, which had been in place for more than a decade. In 2018, after a long gestation period, Chinese A-shares were included in the MSCI Emerging Markets Indices. This further incentivized global institutional investors to increase their exposure to Chinese domestic equities.

The overall policy aim of this process of liberalization is to make the Chinese capital markets, in their broadest sense, more institutionalized. With more institutions determining market directions, and less retail volatility, the Chinese equity markets can better serve the national interest.

Despite this overall direction of travel, there had been one glaring omission: securities lending. This activity was heavily curtailed after the equity market crash of 2015. But it was always likely to become the next major area of the Chinese market to open up, according to banks and experts in the region. At the start of the year, experts in the industry were already indicating that changes were in the pipeline. Speaking to Global Investor at the beginning of the year, one executive from the Pan Asia Securities Lending Association (PASLA) noted that “the development of an efficient securities lending model in China is an obvious focus for PASLA and one to which we have devoted a significant amount of time in 2018. It’s fair to say that all Chinese authorities involved in our discussions have been both engaged and incredibly helpful. This is an exciting area of growth to be involved in as we enter 2019.”

The timing could not have been more auspicious for this new round of structural reform. After all, the Chinese equity markets were the worst performing major equity markets in the world in 2018, with the MSCI China A share index down 20.4% during the calendar year. A pre-condition for reform of securities lending, which some in China still see as being a licence for short sellers, would have been depressed equity markets.

Two further considerations were also apparent in the Chinese authorities’ decision. Firstly, the economic modernization programme of President Xi has caused some to worry about the high levels of domestic debt. A shift from debt financing to equity finance was already a policy goal. But to get international equity into the market, they had to allow investors more flexibility once they were owners of stock. Secondly, behind the scenes there is the ongoing trade negotiations with the US and increasing access to domestic Chinese markets for financial services companies is a large part of the negotiations.These new draft regulations need to be seen in this geopolitical context.

92 Stocks

This is not to say that the securities lending has been completely absent from the Chinese market. The regulations in force on securities lending were promulgated by the CSRC in 2015 – and will remain in force until the new draft regulations come into play. Those regulations allow the Shanghai and Shenzhen stock exchanges to publish a joint list of 92 of the largest stocks that are available for borrowing. However, this is a tiny subset of the overall market. At the time of going to press, there were 2141 companies listed on the Shenzhen Stock Exchange and 1460 on the Shanghai Stock Exchange. Moreover, there is a daily quota for the cumulative value of shares that can be lent. That daily quota has never been met.

Added to the volume restriction on what shares can be lent and borrowed, there are constraints on who can do the borrowing. The CSRC imposes both qualitative and quantitative tests on potential borrowers. As a result of this, the market for securities lending is small. For instance, according to figures from the Chinese Securities Finance Company (CSFC), there is Rmb6 billion ($890 million) outstanding in the domestic securities lending market. But that compares with Rmb460 billion outstanding in the margin lending market. Clearly the authorities have prioritized activities they perceive to be supportive of stock market growth. But after the last year of poor performance that is now due a rethink.

The arguments had been strongly made to the Chinese regulatory authorities that securities lending adds liquidity to markets and allows hedging tools. Both of these are vital if the country is to attain its policy goal of increasing the institutionalization of the domestic equity markets and shifting from debt to equity finance as the engine of growth. “Our continued co-operation with ASIFMA has helped to build on our understanding of how securities finance already worked in China and where we needed to go,” says the executive from Pasla. “Conversations with all relevant parties on the exchange and regulatory front focus on collaboration and working together. Approaching it from that perspective, and understanding what can work and what can’t work, is key to advocating changes to the existing rules.

Market experts urge caution, however, and say that it would be wrong to expect a full liberalization of securities lending. In particular, the draft regulations stipulate that only those who meet the QFII standards can undertake securities lending: it is not open to every investor. “The regulators will do everything in their power to maintain the stability of the market,” says Simon Zhang, a partner at law firm Linklaters in Hong Kong. “In particular they will not want to lessen the rules on who can borrow. We think it is too early for them to reduce the quality of the test on borrowers. According to the latest consultation draft published by CSRC (on January 31), QFIIs will be able to participate in margin trading and securities lending.”

Other market experts agree that any opening will be slow, gradual and dependent on the overall maturity of the market. “In China, the market is not completely mature - and you need it to be mature for a fully open securities lending market,” says David Raccat, CEO and founder of Wematch a securities finance platform based in London. “But they are definitely making moves to open it further.”

Having opened the door wider to allow international investors into the domestic securities lending market, the next path for further reform will be to increase the number of stocks that can be lent. It will also become clear if domestic or foreign owned Chinese securities houses can be involved in the securities lending business, or if it will have to go through the CSFC. These issues will be clarified over the coming weeks and months. But whatever happens, 2019 looks to be an incredibly exciting year for the Chinese securities lending market.

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